What is it Really Worth?

Implementing the Practicability Exception under ASC 2016-01

An adverse economic consequence of COVID-19 that has made headlines is the significant impairment charges business entities have taken related to their non-financial assets, such as intangible assets and goodwill. Less notable has been the pandemic’s similar effect on an entity’s financial assets, including equity securities without readily determinable fair values. Fair value for these types of equity investments is measured in accordance with FASB Accounting Standards Update (ASU) 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01), which is codified within ASC 321, Investments in Equity Securities (ASC 321). The focus of this article is to discuss the measurement alternative method, also referred to as the “practicability exception,” under ASC 2016-01 to recognize and measure fair value for equity investments without readily determinable fair values and the related impairment considerations.

An adverse economic consequence of COVID-19 that has made headlines is the significant impairment charges business entities have taken related to their non-financial assets, such as intangible assets and goodwill. Less notable has been the pandemic’s similar effect on an entity’s financial assets, including equity securities without readily determinable fair values. Fair value for these types of equity investments is measured in accordance with FASB Accounting Standards Update (ASU) 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01), which is codified within ASC 321, Investments in Equity Securities (ASC 321). The focus of this article is to discuss the measurement alternative method, also referred to as the “practicability exception,” under ASC 2016-01 to recognize and measure fair value for equity investments without readily determinable fair values and the related impairment considerations.

Equity Investments Without Readily Determinable Fair Values

FASB ASC 820, Fair Value Measurements (ASC 820) states that the fair value of an equity security is readily determinable if sales prices or bid-and-ask quotations for the security are currently available on a securities exchange registered with the SEC (New York Stock Exchange) or in the over-the-counter market (NASDAQ). Thus, an example of an equity security without a readily determinable fair value within the scope of ASC 2016-01 would be an ownership interest in the nonmarketable equity securities of a private company, assuming the interest is not required to apply the equity method accounting or specialized industry guidance, such as for broker-dealers or investment companies, or interests that result in the consolidation of the investee. Prior to the issuance of ASC 2016-01, an equity investment without a readily determinable fair value was measured at its original cost less any impairment. Under ASC 2016-01, an entity can make an accounting election to either measure the fair value in accordance with ASC 820, with changes recognized in earnings, or use a measurement alternative.

Measurement Alternative

Using the measurement alternative under ASC 2016-01, an entity measures its equity investment without a readily determinable fair value at its original cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for an identical or similar equity instrument of the same issuer. Thus, the measurement alternative represents a hybrid method, combining elements of the legacy GAAP cost method with features of the market approach under ASC 820. An observable price is the price derived from an actual market transaction and an orderly transaction presumes that the transaction was not forced, such as a distressed sale. An example fact pattern of an orderly transaction with an observable price under the measurement alternative would be if ABC owns a less-than-20% interest in the Series A preferred shares of a private company, and the same private company subsequently issues new Series B preferred shares in a private placement offering.

When determining whether an equity instrument issued by the same issuer is like the equity instrument the entity holds, the entity should consider any significant difference in rights or obligations associated with the instruments, such as dividend rights, liquidation preferences, and voting rights. If the instruments are considered to be similar, the entity would adjust the carrying value of its investment to the observable price of the similar security, plus or minus the fair value attributable to any difference in rights or obligations. Presented below are two examples of how an entity may determine whether equity instruments of the same issuer are similar under the measurement alternative and the resulting accounting impact:

Example 1: Series A and Series B Preferred Shares

Fact Pattern	Are the Equity Instruments Similar?
ABC owns Series A preferred shares of a private company. It observes an orderly transaction in Series B preferred shares by the same issuer. The Series A and Series B preferred shares have different dividend rates, but all their other rights and obligations are the same.	Yes. ABC may conclude that the Series A and Series B preferred shares are similar. Therefore, it would adjust, upward or downward, the carrying value of its investment in the Series A shares to their fair value based on the observable price of the Series B preferred shares, adjusted for the difference in dividend rates. Any change would be recorded in earnings.

Assume further the following additional facts in Example 1:

1. Series A preferred share has a carrying value of $100 per share
2. Observable price of Series B preferred share is $150 per share
3. Series B preferred share has a higher dividend rate
4. Incremental fair value attributable to higher dividend rate is $10 per share

As a result, ABC would adjust the $100 carrying value of its Series A preferred shares by $40 per share ($150-$100-$10), with a corresponding increase to earnings.

Example 2: Common Shares and Series A Preferred Shares

Fact Pattern	Are the Equity Instruments Similar?
ABC owns common shares of a private company. It observes an orderly transaction in Series A preferred shares of the same issuer. Owners of the common shares have voting rights and rights to any declared dividends. Owners of Series A preferred shares have rights to a cumulative dividend, liquidation rights, and a non-voting board seat.	No. ABC may not conclude that the common shares and Series A preferred shares of the same issuer are similar due to the differences in rights and obligations. Therefore, it would not adjust the carrying value of its investment in the common shares for this observed transaction.

Impairment Considerations

At each reporting date, an entity that elects the measurement alternative is required to make a qualitative assessment of whether the equity investment is impaired by considering the impairment indicators in ASC 320, Investments in Debt and Equity Securities (ASC 320), including the following indicators which have been more prevalent during the COVID-19 economic environment:

• A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee
• A significant adverse change in the regulatory, economic, or technological environment of the investee
• Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations and working capital deficiencies

If a qualitative assessment indicates that the investment is impaired, the entity must estimate the investment’s fair value in accordance with the guidance in ASC 820, not under the measurement alternative. If the fair value is less than the carrying value, the entity recognizes an impairment loss in earnings equal to the difference. An observable price for an instrument of the same issuer that is not similar but that is below the carrying value of the entity’s investment may also be an indicator of impairment. Referring to Example 2 discussed above, if the observable price of the Series A preferred shares is less than the carrying value of the entity’s investment in the common shares, this could be an indicator of impairment that would require a fair value measurement of the common shares.

In conclusion, applying the measurement alternative to equity investments without readily determinable fair values can be challenging, even more so in the current environment, requiring significant judgment and technical expertise.

This article was originally published in the Spring 2021 edition of Florida CPA Today magazine. It has been reprinted here with the permission of the Florida Institute of Certified Public Accountants.

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Russell Frawley III, MBA, CPA, ABV, has over 25 years of diversified accounting experience, including Big Four public accounting, financial accounting oversight roles at global, public companies, and specialized project-related engagements diverse clientele. His passion throughout his career continues to be the dynamic field of accounting and providing value-added client service. Mr. Frawley holds active licenses as a Certified Public Accountant (CPA) in the states of Florida and Virginia and is a member of the Accounting Principles and Auditing Standards Committee of the Florida Institute of Certified Public Accountants (FICPA). He also is a member and holds the designation of Accreditation in Business Valuation (ABV) from the American Institute of Certified Public Accountants (AICPA). Mr. Frawley earned degrees in Accounting from the University of Central Florida, MBA in Finance and Economics from the University of Miami, and a Certificate in Business Valuation from Florida Atlantic University. He is also an adjunct professor in the School of Accounting at Florida International University (FIU) in Miami, Florida.

Mr. Frawley can be contacted at (305) 546-0776 or by e-mail to Russell@Frawleyco.com.